Chapter 25: Problem 11

Why do sticky wages and prices increase the impact of an economic downturn on unemployment and recession?

Short Answer

Expert verified

Sticky wages and prices increase the impact of an economic downturn on unemployment and recession because they prevent the smooth functioning of supply and demand in the market. Due to their rigidity, labor costs remain high for businesses, leading to job cuts and increased unemployment. Moreover, these rigid wages and prices hinder market flexibility, causing an oversupply of goods and deepening the recession. Together, sticky wages and prices exacerbate economic downturns, leading to higher unemployment rates and a prolonged recession.

Step by step solution

Define Sticky Wages and Sticky Prices

Sticky Prices refer to the resistance of market prices to change promptly despite shifts in the supply or demand. Sticky Wages, on the other hand, are the phenomenon where the nominal wages are slow to decrease even in the face of higher unemployment or economic downturn.

Explain the Economic Downturn

An economic downturn is a decline in economic activity for a specific region or country. It's characterized by several factors, such as falling GDP, reduced consumer spending, higher unemployment, and declining business profits.

The Impact of Sticky Wages on Unemployment

Since businesses tend to avoid cutting wages even during an economic downturn, labor costs may remain high. As revenue decreases due to the downturn, businesses might let go of some employees to cut costs, increasing the overall level of unemployment.

The Impact of Sticky Prices on Recession

Sticky prices may prevent the smooth functioning of supply and demand – if companies cannot lower prices due to existing contracts or regulations, lower demand could lead to an oversupply of goods. This may deepen the recession.

The Synergistic Effect of Sticky Wages and Prices on an Economic Downturn

Together, sticky wages and sticky prices may exacerbate an economic downturn. If firms cannot reduce wages or prices, they may be forced to lay off more employees, further increasing unemployment. This reduction in employment then leads to decreased consumer spending, exacerbating the recession.

Overall Conclusion

Hence, sticky wages and sticky prices contribute to exacerbating an economic downturn into possibly a full-scale recession by maintaining high labor costs for firms that then lead to increased unemployment, as well as preventing a perfect equilibrium between supply and demand, keeping the economy in a downturned state.

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